Understanding Bonus Shares
The news of the issuance of bonus shares brings cheer to the investors. Companies like to reward the shareholders without affecting the cash flows. Investors like to invest in companies that give bonus shares. They consider bonus shares a sign of good health of the company.
Let us understand how the bonus shares work. Bonus shares are issued out of the accumulated profits of the company. The accumulated profits belong to the shareholders, and when not issued as bonus shares, they are still a part of the book value of the shares.
An example will help us understand. A company has issued 10,000 equity shares of ₹10 each. Thus, the total paid-up capital is ₹100,000. The company has accumulated profits (also known as reserves and surplus) of ₹500,000. Thus, the total monies belonging to shareholders is ₹600,000, or ₹60 per share. The company utilises ₹100,000 out of the accumulated profits to issue bonus shares at the ratio of one share against one share held (1: 1) The total capital is now ₹200,000, and the accumulated profits are ₹400,000. You now have two shares instead of the one you owned before. The book value of each share is ₹30 per share, and since you own two shares against each held before, the total book value of the original share plus bonus share put together is ₹60. As you can see, it created no real wealth. The claim of one share was ₹60; now you own two shares. The claim of two shares put together is ₹60. The proportionate right of a shareholder has not changed.
The issue of bonus shares does not impact the profitability of the company in that bonus shares are akin to a stock split; the only difference is that the split changes the face value. Instead of one share of ₹10, now you have two shares of ₹5. The bonus creates additional shares. Instead of one share of ₹10, you now have two shares of ₹10 each. There is no difference in the bundle of rights and obligations.
There is another difference important for an investor to recognise. A company can split shares any time; it need not be backed by any reserves. It is akin to changing a ₹10 note for two ₹5 notes. Bonus shares can be issued out of accumulated profits alone, which means the company needs to have sufficient reserves before it capitalises them as bonus shares.
On the issue of bonus shares, as the shares become ex-bonus, the market price adjusts to the new price. For instance, a company trading at ₹100 issues a 2: 3 bonus. (This means two new shares against three held by a shareholder.) For ₹300, a shareholder that had three shares earlier now owns five shares. Thus, the stock should now trade at ₹60 per share.
Does the price rise after the bonus announcement? It does. The reasons are not psychological as with a split. Let us explore the reasons.
1. The rise in liquidity brings more floating stock. Some people feel they have ‘free’ shares now. It is positive for the investors. Higher floating stock is often correlated with price.
2. Bonus shares are issued out of reserves; it is a celebration of the success of the company. It is a confirmation to the investors that the company is successful.
3. A very important reason that a bonus is important from the point of long-term investors has to do with future payouts. A stable or increasing rate of dividends is what most investors look for in companies as a measure of stability and growth. There is a certain amount of ‘stickiness’ in the dividend that companies pay out. A constant rate of dividends assures the shareholders that all is well with the company. If a company reduces dividends, it sends bad signals to the investors. A company which pays out an increasing rate of dividends must continue to do so. If it does not increase the payout in a particular year, the market becomes alarmed. Company managements are particular not to cause any scepticism by changing the dividends policy.
When a company issues bonus shares, the total share capital is increased to that extent. Keeping the same rate of dividends means paying out more. Dividends being sticky is, in most cases, a corporate policy; a bonus implies a higher amount of dividends in the future.
This is one factor which makes the bonus superior to splits from the point of view of shareholders. A split is often a gimmick to boost the share prices in the short run; bonus shares are long-term commitments.
(Dr Tejinder Singh Rawal is the author of the best-selling book Loads of Money: Guide to Intelligent Stock Market Investing: Common Sense Strategies for Wealth Creation)
Let us understand how the bonus shares work. Bonus shares are issued out of the accumulated profits of the company. The accumulated profits belong to the shareholders, and when not issued as bonus shares, they are still a part of the book value of the shares.
An example will help us understand. A company has issued 10,000 equity shares of ₹10 each. Thus, the total paid-up capital is ₹100,000. The company has accumulated profits (also known as reserves and surplus) of ₹500,000. Thus, the total monies belonging to shareholders is ₹600,000, or ₹60 per share. The company utilises ₹100,000 out of the accumulated profits to issue bonus shares at the ratio of one share against one share held (1: 1) The total capital is now ₹200,000, and the accumulated profits are ₹400,000. You now have two shares instead of the one you owned before. The book value of each share is ₹30 per share, and since you own two shares against each held before, the total book value of the original share plus bonus share put together is ₹60. As you can see, it created no real wealth. The claim of one share was ₹60; now you own two shares. The claim of two shares put together is ₹60. The proportionate right of a shareholder has not changed.
The issue of bonus shares does not impact the profitability of the company in that bonus shares are akin to a stock split; the only difference is that the split changes the face value. Instead of one share of ₹10, now you have two shares of ₹5. The bonus creates additional shares. Instead of one share of ₹10, you now have two shares of ₹10 each. There is no difference in the bundle of rights and obligations.
There is another difference important for an investor to recognise. A company can split shares any time; it need not be backed by any reserves. It is akin to changing a ₹10 note for two ₹5 notes. Bonus shares can be issued out of accumulated profits alone, which means the company needs to have sufficient reserves before it capitalises them as bonus shares.
On the issue of bonus shares, as the shares become ex-bonus, the market price adjusts to the new price. For instance, a company trading at ₹100 issues a 2: 3 bonus. (This means two new shares against three held by a shareholder.) For ₹300, a shareholder that had three shares earlier now owns five shares. Thus, the stock should now trade at ₹60 per share.
Does the price rise after the bonus announcement? It does. The reasons are not psychological as with a split. Let us explore the reasons.
1. The rise in liquidity brings more floating stock. Some people feel they have ‘free’ shares now. It is positive for the investors. Higher floating stock is often correlated with price.
2. Bonus shares are issued out of reserves; it is a celebration of the success of the company. It is a confirmation to the investors that the company is successful.
3. A very important reason that a bonus is important from the point of long-term investors has to do with future payouts. A stable or increasing rate of dividends is what most investors look for in companies as a measure of stability and growth. There is a certain amount of ‘stickiness’ in the dividend that companies pay out. A constant rate of dividends assures the shareholders that all is well with the company. If a company reduces dividends, it sends bad signals to the investors. A company which pays out an increasing rate of dividends must continue to do so. If it does not increase the payout in a particular year, the market becomes alarmed. Company managements are particular not to cause any scepticism by changing the dividends policy.
When a company issues bonus shares, the total share capital is increased to that extent. Keeping the same rate of dividends means paying out more. Dividends being sticky is, in most cases, a corporate policy; a bonus implies a higher amount of dividends in the future.
This is one factor which makes the bonus superior to splits from the point of view of shareholders. A split is often a gimmick to boost the share prices in the short run; bonus shares are long-term commitments.
(Dr Tejinder Singh Rawal is the author of the best-selling book Loads of Money: Guide to Intelligent Stock Market Investing: Common Sense Strategies for Wealth Creation)
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